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December 3, 2011

How to Avoid the Coming ETN Meltdown

The overriding theme is to immediately cut direct credit exposure to banks by moving into ETFs

NYSE traders reacting to falling stock prices. (Photo: AP)

Today, there’s roughly $15 billion parked inside 196 U.S. listed exchange-traded notes, also known as ETNs. And with global banking system on the edge, ETN shareholders are smack dab in the middle of the storm.

Which ETN providers will go bust first? How can investors avoid impending disaster?

ETNs are not ETFs: While ETNs and exchange-traded funds (ETFs) are sometimes grouped together, or worse, confused as the same thing, they are not.

Unlike traditional ETFs, exchange-traded notes are debt obligations backed by the financial or banking institution that issues them. ETNs pay a return linked to the performance of a single security or index. Who pays the return? The financial issuer backing the note.

ETNs can track a variety of assets from commodities (DJP), to the VIX Index (VXX) and master limited partnerships (AMJ). ETNs are also used as day trading instruments for those that want leveraged long exposure (DGP) or leveraged short (DZZ) to gold or other assets.

Investors that choose to keep their ETN to maturity receive a cash payment, calculated from the beginning trade date to the ending period, or maturity date. The annual fees deducted reduce the value of the payment.

Maturity periods can vary and may be as long as 30 years. ETN investors that don’t want to hold their note to maturity can sell it prior to maturity on the exchange where they trade.

Faltering Credit Worthiness

In an online survey of ETFguide’s readers, 48% responded that credit ratings are not accurate, while 45% responded that credit ratings are only “somewhat accurate.”

This viewpoint concurs with mine that credit ratings are second rate. Nevertheless, they offer us a general idea about the trend in creditworthiness among ETN issuers.

Standard & Poor’s just cut the credit score for more than a dozen global banks. Other raters like Fitch Ratings and Moody’s, have negative views on banks, too, and more downgrades are ahead.

While these credit opinions still overestimate the true credit worthiness of large banks, they show the cycle of deteriorating credit quality is accelerating, not decelerating.

Would you want to lend your money to distressed borrowers on the verge of bankruptcy? What about borrowers that need to keep borrowing more and more money in order to stay afloat?

Yet, this is exactly what you do when you buy an ETN. No matter what the press releases or the CEOs say, both global (EUFN) and domestic banks (KBE) are caput without outside assistance from the Federal Reserve or ECB.

What if Europe’s banks get bailed out? Does the credit risk of ETNs go away?

European banks have been and continue to receive a financial lifeline, but it still doesn’t change the fact that when you buy an ETN, you’re buying a financial promise from an institution.

Four of the five largest ETN providers are based in Europe. Who in their right mind would lend money to them?

Other than desperate quasi-government establishments trying to avert a total collapse of the banking system, suckers are a good bet to keep lending their money to banks. And as P.T. Barnum said, “There’s a sucker born every minute.”

Overlooked ETN Problems

Another rarely discussed problem with ETNs is that they complicate the asset allocation process that so many financial professionals subscribe to. Asset allocation is the process of dividing up your investments across various categories, like stocks, bonds, cash, real estate, and so forth.

But here’s how ETNs dupe asset allocators: Even though the investor assumes he has market exposure to precious metals when buying a precious metals ETN like the iPath DJ-UBS Industrial Metals ETN (JJP), the investor really has exposure to debt from Barclays Bank.

What’s does it mean? It means the investor has unwittingly increased the fixed-income portion of his portfolio’s asset allocation to bonds instead of getting the exposure to the precious metals that he wants!

Don't be a victim; history is repeating itself. ETFguide’s December 2011 ETF Profit Strategy Newsletter provides a short list of the 15 largest U.S. traded ETNs and immediate alternatives that invest in the same categories.

One example is the iShares S&P Nifty Fifty ETF (INDY), which can be used in the place of the iPath MSCI India ETN (INP). The overriding theme is to immediately cut direct credit exposure to banks.

During the 2008-09 Financial Crisis, the ETNs issued by Lehman Brothers got clobbered and eventually became worthless.

Today, the $15 billion market for ETNs in the U.S. is much larger than it was three years ago, which means one thing: This time around, the same ETN blowup that’s on the verge of occurring will much larger in scale and much uglier.

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